The arrival of short-term interest rates at the zero bound has changed U.S. monetary policy irrevocably. The Fed’s asset purchases have exceeded a quarter of concurrent GDP over the course of 6 years, compressing term and credit premiums by unprecedented margins, with no reversal in sight. Forward guidance has reduced market uncertainty and raised the credibility of a persistently expansionary stance. Excess stimulus and economic conditionality have become prevalent. The flipside is increased dependency of the financial system on the continuation of such accommodative conditions.
The 1×1 of financial repression
Financial repression is a policy that channels cheap funding to governments, typically supported by accommodative monetary policy. After the global financial crisis various forms of financial repression have prevailed in most developed and many emerging countries. These policies have been effective in containing public debt but bear risks for future financial stability.
Volatility markets: a practitioner’s view
Christopher Cole argues that volatility markets are about trading both known and unknown risks. These risks require different pricing and cause different “crashes”. Most portfolio managers either hold implicit short volatility or long volatility positions. After the great financial crisis, monetary policy has suppressed volatility, but steep volatility curves are indicating a “bull market in fear”.
The Federal Reserve’s reliance on macroprudential policy
In a recent speech Federal Reserve Chair Yellen has emphasized the economic cost of making financial risk a key consideration of monetary policy. While accommodative and non-conventional monetary policy may boost risk taking, enhanced regulation should secure financial system resilience and contain excesses. Only when macroprudential policy cannot achieve that goal should monetary policy step in. That time would not be now.
The volatility paradox
Brunnermeier and Sannikov illustrate in a formal model why fundamental risk and asset market volatility can be out of sync. They focus on endogenous market dynamics, such as “collateral amplification” (the mutual reinforcement of credit conditions and asset values). These endogenous dynamics imply that [i] low-risk environments foster systemic risk, [ii] market reactions to negative fundamental shocks are non-linear (i.e. can become catastrophic when the shock is large) and [iii] financial market risk can de-couple from fundamental risk.
Understanding capital flow deflection
A new academic paper asserts strong empirical evidence for capital flow deflection: one country’s capital inflow restrictions re-direct capital flows to other countries with similar economic characteristics. While the paper investigates from a policymaker angle, it would be relevant for international macro trading strategies.
The “net stable funding ratio”: a basic briefing
The “net stable funding ratio” is a quantitative liquidity standard for regulated banks, scheduled to go into effect in 2018. It will require stable funding sources to be equal or exceed illiquid assets. It may to some degree restrict term transformation of regulated banks and encourage migration into shadow banking. The impact of the new regulation will differ across countries and institutions.
Why governments have financial interest in higher inflation
With G7 public debt stocks at record highs, inflation has become a key fiscal concern. A new IMF paper estimates that a fall of inflation to zero would raise debt ratios by another 5-6%-points. A rise of inflation to 6% would lower debt ratios by 11-18%-points of GDP through real debt erosion. Inflation would offer additional fiscal benefits, such as higher revenues through “seigniorage” and progressive income tax tariffs.
How human stress increases financial crisis risk
John Coates gives a neuroscience view on how human “stress response” can aggravate financial crises. Rising market volatility causes a bodily response in form of a sustained elevation of the stress hormone cortisol in traders and investors. This raises risk aversion and may contribute to institutional paralysis. Central banks’ policies aimed at keeping markets calm in normal times may weaken traders’ immune system.
How statistical risk models increase financial crisis risk
Regulators and financial institutions rely on statistical models to assess market risk. Alas, a new Federal Reserve paper shows that risk models are prone to creating confusion when they are needed most: in financial crises. Acceptable performance and convergence of risk models in normal times can lull the financial system into a false sense of reliability that transforms into model divergence and disarray when troubles arise.
